Gesto, Inc., has an issue of preferred stock outstanding that pays a $4.70 divid

Question

Gesto, Inc., has an issue of preferred stock outstanding that pays a $4.70 dividend every year, in perpetuity.

Required:

If this issue currently sells for $79.95 per share, what is the required return?

If the company plans to pay a dividend of $4.05 next year, what growth rate is expected for the company’s stock price?

You own a portfolio that has $2,300 invested in Stock A and $3,400 invested in Stock B. Assume the expected returns on these stocks are 9 percent and 15 percent, respectively.

What is the expected return on the portfolio?

Explanation / Answer

1. Gesto Inc.
Value of the preferred stock can be calculated as follows
Value of Preferred Stock = Dividend / Required return
79.95 = 4.7 / Required return
Required return = 4.7 / 79.95 = 5.88%

2. Jenkins Co.
Price of a company using Gordon growth model can be calculated as follows
Price of Stock = Next year Dividend / (Required Return - Growth rate)
54.80 = 4.05 / (14.0% - Growth rate)
(14.0% - Growth rate) = 4.05 / 54.80
14.0% - Growth rate = 7.39%
Growth rate = 14.0% - 7.39% = 6.61%

3. Portfolio return can be calculated as follows
Portfolio Return = Sum of (Weight of Stock * Return on stock)

Total value of portfolio = 2300 + 3400 = 5700
Weight of Stock A = 2300 / 5700 = 40.35%
Weight of Stock A = 3400 / 5700 = 59.65%

Portfolio Return = 40.35% * 9.0% + 59.65% * 15% = 3.63% + 8.95% = 12.58%

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